Fixed Exchange Rates and Recession

A South America country with fixed exchange rate system has close economic ties with the USA symbolized by extensive trade and unrestricted flow of capital between the two countries. The economy of this country is in recession and the president of the country tries to get the central bank to intervene and help the economy out of the recession using monetary policy. In a meeting with governor of the central bank, the country's president cites Federal Reserve Board's expansionary monetary policy in the USA during the 2001-2003 period to persuade the governor, but the governor takes the position that the central bank should not intervene.

Do you agree or disagree with the position taken by the governor? Justify and explain your answer using IS-LM curves. Describe precisely each step in the process that you present to explain your answer and label the steps as a, b, c, d, etc, to clearly show the sequence of events and understanding of it for practice problem.

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A fixed exchange rate requires that the central bank intervene to keep the currency from changing value. Market forces will tend to move the exchange rate away from where it is fixed. If the exchange rate is tending to increase, thus devaluing the domestic currency, the central bank will need to buy domestic currency and sell foreign currency to balance this force.

The governor in this case understands that the central bank cannot affect the economy in the same was as the US Federal Reserve, which is not hindered by a fixed exchange rate. Here are the steps that will occur when a country with a fixed exchange rate attempts to use expansionary monetary policy.

a. See Figure 1. Here, the economy is at point E, before the expansionary monetary policy has been implement.